Opinions differ on effectiveness of FICO score

Today's Minneapolis Star Tribune reports that a mortgage lender and credit-rating agency have taken to blaming FICO scores for the rising number of subprime mortgage defaults in their article, Opinions differ on effectiveness of FICO score.

Any opinions from the FICO scoring experts here as to the validity of this claim?

Re: Opinions differ on effectiveness of FICO score

Someone can have a score of 850 and have a devastating life event and be unable to pay their bills, including mortgage. They could wind up in foreclosure in a minute and find that they have to redeem themselves for years to come as a result. This is something that FICO nor creditors take into account. While someone who has perfect credit will be more likely to find a way to pay their bills at any cost, some things in life just aren't guaranteed, even for the best of the best.

I think it's very unfair to blame FICO for the historic rise in foreclosures. If you're dealing with sub-prime customers who have a long history of defaults, the risk is far greater, as can be expected, and that's the lenders' faults.

I think this is just a ploy by the CRA's to promote their horrid scoring systems.

Re: Opinions differ on effectiveness of FICO score

Obviously article details are sketchy, at best. The underlying variables are complex.I'm inclined to find a certain parallel in the subprime mortgage market to the below investment grade (junk) bond market in the '80s. While conventional wisdom had been for prudent investors to avoid purchase of subprime bond issues, analysis found that those who invested in them consistently generated income superior to that of standard issues, even after taking defaults into account. (In other words, investors were being overcompensated for risk.)

Thus was born a raging market that grew to proportions which the theoretical analysis could hardly be expected to reflect. It was an entirely different environment (among other things, shaky firms that formerly would never had access to the debt markets now found a market for their bonds).

So, my first inclination is to wonder whether some mortgage companies (such as HSBC) may have looked a little too eagerly at the profitability prospects of the subprime mortgage market -- again, ultimately expanding subprime loan portfolios to a degree that weakened the assumptions under which FICO scores might be applied to that subcategory of borrowers in predicting default risk.

Plus, quite frankly, we only have HSBC's word that they diligently underwrote mortgages, and didn't extend loans more aggressively than what would be warranted by respective FICO scores.

It should be apparent that, given the underlying motivations of lenders vs. FICO, I suspect that lender profit objectives would be more likely to lead them to misuse scoring information than for FICO to fail in its product analysis.

That said, FICO is impeded in product development for this particular borrowing sector by the fact that it's relatively young and less established than other mortgage segments. That puts considerable risk that should subprime mortgage portfolios swell, FICO's models may be impaired in predicting default risk.

There are no absolutes involved here, but I assign the bulk of default responsibility to the lenders in any event.

As an aside, it would be useful to clarify what's under fire re FICO here? There's a big difference between observing that overall default rates are unexpectedly high vs. that FICO scoring isn't adequately predicting which borrowers pose the greater default risk. The former seems to be the focus of the article, but it would be the latter that would be the truer measure of FICO scoring effectiveness.

Today's Minneapolis Star Tribune reports that a mortgage lender and credit-rating agency have taken to blaming FICO scores for the rising number of subprime mortgage defaults in their article, Opinions differ on effectiveness of FICO score.

Any opinions from the FICO scoring experts here as to the validity of this claim?

-Barry

Well, any system that dings someone for being honest and trying to settle a past debt is suspect.

Seriously, the whole credit scoring system is in dire need of reform. At the very least:

1) Quality control needs to be enforced on items listed in credit reports. Any listing on a credit report should have to include, accurately: the account number, the balance, the date of last delinquency, the current status of the account, the type of account, the original creditor, the current creditor, and full contact information for both. No exceptions. If ANY of this information is missing, the credit bureaus should be BANNED from accepting the listing in the first place.

2. No account should be listed more than once. Say you have a power bill and you don't pay it. The power company lists it as 30, 90, 120 and finally charges it off. They should be allowed to list it and update the status as it changes. Two months later they turn it over to a collection agency. The collection agency should NOT be allowed to start a second listing of the SAME debt! The EXISTING listing should be updated, the account changed to "charged off," and an entry in the listing added for the current creditor: the collection agency, with full contact information. At that moment, an "anchor" should be dropped at the first date of delinquency, and that date will be PERMANENTLY fixed as the effective date as far as FICO is concerned. No endless re-reports and re-listings. The debt is there, the default is there, and that's where it remains. If the consumer comes along and pays the charge-off, this does NOT affect the anchored date, and therefore does NOT ding FICO. The status is merely updated to "paid charge-off" and that's that.

Re: Opinions differ on effectiveness of FICO score

Think about this: "rising number of subprime mortgage defaults" OK, what makes them "subprime"? A LOW FICO SCORE. Which INDICATES A HIGHER RISK OF DEFAULT. And these people are complaining about a higher rate of default on higher risk loans? ? FICO may be accurate, or it may not be accourate, but it has nothing to do, I think, with the subprime mortgage problems. Those problems came from bad lending practices. What shelters a lender from loss more than anything else? A borrower who has and accumulates equity in his house. What happened during the last 2 or 3 years or so? There were a whole bunch of new kinds of loan where the borrower didn't have any equity going in, and didn't build any equity for many years. And FICO is to blame for this? REALLY? I hold no brief for FICO, all I know about it is that it seems to be accurate in my case. But blaming anybody or anything (including supposedly "deadbeat" borrowers) for irresponsible lending practices is just a cowardly ducking of responsibility.

Re: Opinions differ on effectiveness of FICO score

S/P or prime your still taking a risk. Nowadays people want to get into a home so bad that all that anyone seems to focus on is the score to look good coming in the door. Then they have no doc no income verification based on score. So I could have a 760 or higher and make 28k trying to get into a 300k home. How can I pay for this? If that is your only income the answer is you can't! some people are not educated enough on the total cost of a home and the expenses that come with it. It still comes down to the almighty dollar my friends. Lenders would not make the loan unless they are making money. They don't care six months down the line when they are foreclosing!

Re: Opinions differ on effectiveness of FICO score

Mike, you make some good points. However, in closing my post I raised a question that should be given some consideration -- what is it that's being criticized?

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An HSBC exec is quoted in the article as saying that FICO scores were "less effective or ineffective" in predicting behavior during a period of aggressive lending and low interest rates.

I doubt there was any question in HSBC's mind that they would suffer a higher default rate in their subprime portfolio than with higher credit borrowers. But the HSBC statement suggests that they feel the FICO product in question didn't appropriate identify that risk.

We don't know what FICO asserted for this product. We do know that when FICO profiles our personal scores that it cites very specific default risk for each credit score band. I don't think it's unreasonable that thie FICO product did as well for this subset of subprime borrowers -- quite possibly in a very well defined manner.

HSBC may have relied upon this data to determine what mortgage risks they would underwrite and at what rates - FICO offering up a fairly specific indicator of expected default cost under their model. If the model proved to be inaccurate and a higher than indicated default rate occurred (taking into account economic conditions), then there's room for lenders to hold FICO at fault, at least in part, for the unexpected poorer loan performance.

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The article gives good indication that this perceived ineffectiveness in predicting defaults is the crux of the matter. Note the following statement from Vantage:

"Absolutely, it helps us," said Barrett Burns, VantageScore's chief executive. "It offers us a great opportunity for lenders to look at VantageScore. Since our score is more accurate and predictive, there would have been improvement" in mortgage defaults had the industry used VantageScore instead of FICO, he said."

The gist is that the Vantage product is asserted to more accurately predict default rates for these borrowers then FICO. To the extent that Vantage should more accurately identify a stronger default risk vs. FICO, lenders would reign in lending (using the same underwriting standards) and, thus, experience lower defaults -- or, at least would price loans more accurately and thus not suffer the adverse profit consequence of the higher default rate.

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What's problematic here is that we don't have any data whatsoever from which to assess whether the FICO product was inaccurate in predicting degree of default risk. Short of that, we're in an inadequate position to make a reliable call on the situation.

Still, the statement from Fitch Ratings in the latter part of the article gives good credance that the FICO product isn't likely at fault. Fitch argues that lenders, anxious to assume these loans, weakened underwriting procedure by, amont other things, requiring less income documentation. The consequence of inadequate income doc is that if borrowers successfully misreprented their income as stronger that the actual case, the lenders put themselves in the position of likely overextending loan amounts.

In other words, FICO default predictions are based upon a given underwriting process (those standards prevalent during the period over which data was compiled and analyzed). If lenders should then become more aggressive in pursuing the subprime market (presumably because they have new confidence in possessing a new tool that will more accurate predict defaults) and make the application process less stringent in the process (e.g. lower loan doc reqs), then actual default rates will necessarily vary from those predicted by the FICO model.

Consider this analogy: We're told in our myFICO score report analysis that 14% of borrowers with scores between 650 and 699 will "get into serious credit trouble". This assumes that lenders continue existing lending practices. However, if lenders began assigning much higher credit limits for applicants in this credit band, or simply approve a higher percentage of applicants, there's no question that default rates would rise. The FICO score predictor would be meaningless in light of a change in lending practice.

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We don't have sufficient data to make a definitive call on the questions raised here; we can only make some reasoned guesses, at best.

Personally, I find it much more probable that lenders have inapporpriately applied the FICO data in making underwriting decisions than that the FICO model predictions were inaccurate.

But I'd be deluded if I thought there wasn't good room for things to be just the other way.

Re: Opinions differ on effectiveness of FICO score

Then they have no doc no income verification based on score. So I could have a 760 or higher and make 28k trying to get into a 300k home. How can I pay for this? If that is your only income the answer is you can't!

This suggests that no doc loans are a bad business practice. Bear in mind that they legitimately serve a borrower subset. This includes borrowers such as contractors who can't simply turn over a w-2 and may, with good reason, find it undesirable to turn over their tax return. The key is that such loans aren't extended irrationally.

Bear in mind that, among other things, high equity rates are required. Frankly, if someone pops down $100K on that $300K home, the mortgage company isn't going to hurt too terribly in the event of default ... there's ample room from which to recover all expenses from the sales proceeds -- even at a depressed price from an attempt to unload the home quickly. Plus, such loans are priced at a premium over others, allowing greater profitability despite a marginally higher default rate than standard loans. In general, this is a product that likely yields a high confidence of profitability.

Remember, it's not the bank's role to protect you from overextending yourself. It's simply their mission to profitably lend.

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